Valuation of Stock

Basics of Stock Valuation

Common stock Valuation with no growth
Common Stock Valuation: The Constant Growth Case
Common Stock Valuation: The Non=Constant Growth

Case
Required Return
Illustration

Basics of Stock

Stockholders own the corporation, but in many instances the

corporation is widely held. Stock ownership is spread among
a large number of people

Because of this, most stockholders are only interested in how

much money they will receive as a stockholder Most equity
investors arent interested in a role as owners

Common Stock Versus prefered Stock

Valuation of Common Stock is more difficult than bond because

of
Cah flow is not known in advance
In principle, life of a stock is unlimited
-No easy way to know the required rate of return

Common Stock Cash Flows and the Fundamental Theory of Valuation

In 1938, John Burr Williams postulated what has become the fundamental

theory of valuation:

The value of any financial asset equals the present value of all of its
future cash flows.
For common stocks, this implies the following:

D1

D1

P 1 D2

D1

D2

D2

D3

P2

P2

D4

Common Stock Valuation: The Zero Growth Case

According to the fundamental theory of value, the value of a

financial asset at any point in time equals the present value of all
future dividends.

If all future dividends are the same, the present value of the

dividend stream constitutes a perpetuity.

The present value of a perpetuity is equal to

C/r or, in this case, D1/r.

Question:

Cooper, Inc. common stock currently pays a $1.00

dividend, which is expected to remain constant
forever. If the required return on Cooper stock is
10%, what should the stock sell for today?

Answer:

P0 = $1/.10 = $10.

Question:

Given no change in the variables, what will the stock

be worth in one year?

Common Stock Valuation: The Zero Growth Case (concluded)

Answer:

One year from now, the value of the stock, P1, must
be equal to the present value of all remaining future
dividends.

Since the dividend is constant, D2 = D1 , and

P1 = D2/r = $1/.10 = $10.
In other words, in the absence of any changes in expected cash
flows (and given a constant discount rate), the price of a nogrowth stock will never change.
Put another way, there is no reason to expect capital gains income
from this stock.

Common Stock Valuation: The Constant Growth Case

In reality, investors generally expect the firm (and the dividends it

pays) to grow over time. How do we value a stock when each dividend
differs than the one preceding it?
As long as the rate of change from one period to the next, g, is

constant, we can apply the growing perpetuity model:

D1

D2

D3

D0(1+g)1

D0(1+g)2

D0(1+g)3

Now assume that D1 = $1.00, r = 10%, but dividends are expected to

increase by 5% annually. What should the stock sell for today?

Common Stock Valuation: The Constant Growth Case (concluded)

Answer:

The equilibrium value of this constant-growth stock is

D1

$1.00
=

r-g
Question:

= $20
.10 - .05

What would the value of the stock be if the growth rate

were only 3%?

Answer:

D1

$1.00
=

= $14.29.

r-g
.10 - .03
Why does a lower growth rate result in a lower value?

Stock Price Sensitivity to Dividend Growth, g

Stock price ($)
50
45

D1 = $1
Required return, r, = 12%

40
35
30
25
20
15
10
5
0

2%

4%

6%

8%

10%

Dividend growth
rate, g

Stock Price Sensitivity to Required Return, r

Stock price ($)
100
90
80

D1 = $1
Dividend growth rate, g, = 5%

70
60
50
40
30
20
10

Required return, r
6%

8%

10%

12%

14%

Common Stock Valuation - The Nonconstant Growth Case

For many firms (especially those in new or high-tech industries),

dividends are low and expected to grow rapidly. As product markets

mature, dividends are then expected to slow to some steady state
rate. How should stocks such as these be valued?
Answer: We return to the fundamental theory of value - the value today

equals the present value of all future cash flows.

Put another way, the nonconstant growth model suggests that

P0 =

present value of dividends in the nonconstant growth period(s)

+ present value of dividends in the steady state period.

Non-constant Growth cont..

Components of Required Return

Po = D1/(R-g)
R-g = D1/Po
R = D1/Po + g

Required rate of return = Dividend yield + capital gain Yields

Illustration 1

Suppose a stock has just paid a $5 per share dividend. The dividend is

projected to grow at 5% per year indefinitely. If the required return is 9%,

then the price today is _______ ?
P0 = D1/(r - g)

= $5

(1+.05)/(.09-05)

= $5.25/.04
= $131.25 per share

What will the price be in a year?

Pt

= Dt+1/(r - g)

P1 = D2 /(r - g) = ($5.25 X 1.05)/(.09 - .05) = $137.8125

By what percentage does P1 exceed P0? Why?

Illustration 1: Problem 2

MegaCapital, Inc. just paid a dividend of $2.00 per share on

its stock. The dividends are expected to grow at a constant

6 percent per year indefinitely. If investors require a 13
percent return on MegaCapital stock, what is the current
price? What will the price be in 3 years? In 15 years?

According to the constant growth model,

P0 = D1/(r - g) = $2.00(1.06)/(.13 - .06) = $30.29

If the constant growth model holds, the price of the stock

will grow at g percent per year, so

P3 = P0 x (1 + g)3 = $30.29 x (1.06)3 = $36.07, and

P15 = P0 x (1 + g)15 = $30.29 x (1.06)15 = $72.58.

Illustration 2: Required Rate of Returns

Required rate of return = Dividend yield + capital gain Yields
Example:Suppose a stock has just paid a $5 per share dividend.

The dividend is projected to grow at 5% per year indefinitely.

If the stock sells today for $65 5/8, what is the required rate of
return?
r

$5.25/$65.625 + .05

dividend yield (_____) + capital gain yield (_____)

D1/P0 + g

Illustration 3: Valuation with non constant growth

Suppose a stock has just paid a $5 per share dividend. The

dividend is projected to grow at 10% for the next two

years, the 8% for one year, and then 6% indefinitely. The
required return is 12%. What is the stocks value?

Time Dividend

$ 5.00

$ ____

(10% growth)

$ ____

(10% growth)

$6.534

( __% growth)

$6.926

( __% growth)

Illustration 3 (concluded)

At time 3, the value of the stock will be:

P3

D4/(r - g) = $6.926 /(.12 - .06) = $115.434

The value today of the stock is thus:

P0

D1/(1 + r) + D2/(1 + r)2 + D3/(1 + r)3 + P3/(1 + r)3

$5.5/1.12 + $6.05/1.122 + $6.534/1.123 + $115.434/1.12---

$96.55